Paul Krugman and Steve Keen had an argument

I have been going over a heated debate from early last year between economists Paul Krugman and Steve Keen and I would like to set down a few thoughts about it. Let me right off state for the record that I am one of those who believe that Mr. Krugman came off much the worst of it. That does not mean that I am entirely satisfied with either the diagnosis or prescription offered by Mr. Keen.

The issue was basically over the efficacy of central bank monetary policy in curing or preventing recessions. Mr. Krugman has high confidence that central bank monetary policies, if conducted properly, have almost unlimited power to control levels of aggregate demand and thereby prevent or terminate major deviations from full employment and stable consumer prices in the aggregate. Mr. Keen however, argues that in the modern banking system private commercial banks, not the government's central bank, are in effective control of the "endogenous money" supply, and it is their willingness to lend that is the major determinant, at least on the margin, of aggregate demand.

Mr. Keen is a follower of Hyman Minsky who authored a famous theory of financial instability, which I regard as basically a theory of financial psychology not unrelated to Keynesian "animal spirits". While Mr. Krugman invites us to seek comfort and shelter in government regulation of money and banking, Mr. Keen's alternative view would seem to leave the economy exposed to inevitable Minskian financial tempests. Actually, Mr. Keen does have an interesting proposal of "Jubilee shares" which may well have merit for preventing excess speculation and volatility in the equity markets but I do not believe it adequately solves the general financial instability problem. It could even make it more acute.

I do not see, as Minsky or Keynes did, psychology as a driving force of financial excess. It would be fair to say that on this point I share Mr. Krugman's skepticism of the "confidence fairy". Rather I think financial instability results from too much "liquidity" -- a.k.a. "credit", a.k.a. "debt". Because all debt anticipates payment in the future all debt borrows from the future. Debt effectively "consumes" future resources by committing them to present needs. The obvious danger lies in "eating the seed corn" -- short-sighted consumption of resources that leaves us poorer over time. If more credit is used than is consistent with sustainable consumption over the long term then the excess liquidity, for lack of productive alternative, must flow into waste and speculation -- the former being the untimely depletion of valuable resources, shrinking the economic pie, and the latter being a form of gambling which on balance punishes saving and production to reward rent-seeking, reallocating the economic pie. Psychology has little to do with it.

With endogenous money theory, demand for credit brings forth its creation and that does indeed suggest that investor or business or consumer psychology, being a source of normal credit, is also responsible for excessive credit. But money is also created exogenously by central banks. Central banks purposefully create enough credit to target a positive, "modest", level of consumer price inflation as a hedge against a dreaded deflationary spiral. I believe this monetary stimulus is enough to create and sustain asset bubbles which only grow in time until they must eventually burst, causing waste and speculation along the way.

Getting back to Mr. Keen's "Jubilee shares", they might well accomplish the goal of protecting equity markets from speculative liquidity inflows but the excess liquidity would simply have to go somewhere else -- likely to some place where it would be harder to notice and cause even greater economic harm. It is also over complicated. The complications are arbitrary in nature and designed to forestall some obvious problems and are, to me, a sure sign that the basic idea is fundamentally flawed.

Simpler and more promising, I believe, is a general financial transaction tax -- a generalization of a tax on currency trading recommended in 1972 by economics Nobel Laureate James Tobin specifically as a means to reduce volatility and speculation in that market. However, while such a tax would make a more complete dam and levy system to wall off more of the financial sector from inflows of excess liquidity it still fails to prevent the excess liquidity in the first place. Maybe it would be enough to save the real economy from Too Big to Extinguish Debt, (the real problem behind Too Big to Fail Banks), but I am not sure.

Financialization of the economy

When financial markets have more liquidity than can be invested in the real economy then it goes into speculation. The speculators, which includes banks, other financial institutions such as hedge funds and some wealthy individuals, are plainly getting rich so if it isn't coming from producing valuable products and services for consumers then it is necessarily extractive; i.e., it comes from claiming a bigger share of the pie. Better regulation is a fine idea but by itself it will be largely defeated because ways to speculate will always be found as long as liquidity is excessive.

Why is liquidity excessive? It has been at least since the 70s when the last link between the US Dollar and gold was severed allowing the Fed freedom to manage the money supply mainly for the purpose of avoiding recessions. The strategy for accomplishing this was to aim for a steady, moderate rate of price inflation. In an economy without a fiat money supply a certain amount of price deflation is natural due to technological advance and accumulation of capital resulting in rising productivity. I believe persistent excess liquidity resulting in speculation, excessive debt and the financialization of the economy is due precisely to the anti-recessionary strategy of the Fed, (also adopted by other central bankers). Unless we find a better way to either avoid or live with recessions, speculation and anti-productive financialization of the economy is sure to continue regulatory reforms notwithstanding.

Central bankers too wed to status quo

Mervyn King: Regulators can't rely on bank models

WASHINGTON (MarketWatch) -- Global bank regulators cannot rely on models financial institutions use for themselves to identify if there is too much risk in the system, said Mervyn King, governor of the Bank of England, on Monday. "It is the case that conventional calculations of risks and how much capital banks need turn out to be irrelevant from one day to the next," he said. King added that regulators must identify two or three major developments that are creating risks and "then have the courage to go in and tackle them."

No, regulators must have the courage to go in and build firewalls, or better yet break the big banks into separate corporate entities, so that most banking is of a conventional sort where conventional calculations of risks and how much capital banks need turn out to be relevant from one day to the next and to put the rest of financial activity into separate realms for speculators who can put few at risk besides themselves. Mr. King's advice is really nothing but to trust once again to essentially the same regulatory framework and financial structure that has already failed us. It would inevitably once again allow the nest eggs of pension funds and insurance companies to be misused by financial "innovators" who are mainly expert in finding creative ways to make highly leveraged bets seem much less risky than they really are.